How to protect yourself against inflation

Inflation is here, and it’s much higher than expected. Recent data shows that that the prices of commodities and materials are skyrocketing, with Lumber up +326% in a year, Copper +86%, Palladium +54%, Corn +91%, Soybeans +85%, and Iron Ore +112%. Meanwhile, the March CPI (Consumer Price Index) rose 0.7% in the UK and 0.6% in the US, which represent 8.4% and 7.2% annual inflation rates, respectively; and while the Federal Reserve defines these price increases as “temporary”, the cost of living is starting to rise sharply for consumers. In fact, according to a CNBC survey, in the last 12 months, the cost of Grocery has gone up by 2.6%, as well as Household Care (+5.2%), Baby Care (+7%), and General Merchandise (+7.1%). In confirmation of this data, ING Chief International Economist James Knightley is forecasting consumer prices will continue to rise in the near term and could gain almost 4% by May.

Many companies in the US and around the world used the earnings season to express their plans to raise prices in what Andre Schulten, Procter&Gamble’s finance chief, described as “one of the swiftest rises in commodities costs” he has seen in his career. Companies from every industry are witnessing a sharp increase in costs, which consumers will inevitably pay for: Coca Cola, for example, is facing margin pressures from rising costs of commodities like fructose, corn syrup, and packaging materials, while Whirlpool is planning price rises of between 5 and 12 percent to cope with an expected US$ 1 billion hit from higher input costs. John Murphy, chief financial officer at Coca Cola recently said that “We have a tied and true practice of being able to take pricing in line with inflation”, whereas last month a survey from the National Association of Manufacturers showed that 76% of its members fear the increase in costs of raw materials and see it as their biggest threat in 2021. Also, the average US existing-home price for all housing types in March was US$329,100, up 17.2% from March 2020 ($280.700), as prices increased in every region, according to the National Association of Realtors. And while a rise in inflation may not change much for wealthy individuals that have millions of dollars invested in assets, since the cost of living only represents a small fraction of their wealth, it becomes a burden for those whose cost of living is almost equal to their income.

So, what can the average investor do in order to protect its savings from the long claws of inflation?

Are stocks a good idea?

Stocks are commonly viewed as a good instrument against inflation, but like everything common, it’s not always the best solution. In fact, it’s not an exaggeration to say that the stock market as a whole is extremely overvalued right now, with the average p/e ratio of the S&P 500 of over 40x and margin debt at all-time highs, making investments riskier. Also, if we look at the relationship between inflation and stock prices from 1926 through 2002, we can see that in the years when the prices of consumer goods and services fell, stock returns were horrible, with the market losing up to 43% of its value. However, when inflation exceeded 6%, the stock market also sank, losing money in 8 of the 14 years in which inflation was that high, and performing a miserable 2.6% on average in those 14 years. That is because while normal levels of inflation allow companies to pass the increased costs on to consumers, high levels of inflation slash purchases and depress the economy. Overall, by looking at the historical evidence, in the 77 year period between 1926 and 2002, stocks outperformed inflation 78% of the time, which means they failed to protect the investor’s purchasing power about one-fifth of the time. (Source: The Intelligent Investor)

"Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars worth of groceries. Today, a five-year-old can do it." -Henry Youngman

An acronym to the rescue

One of the best inflation fighters of our times: TIPS. Treasury Inflation-Protected Securities are US government bonds that automatically go up in value when inflation rises. Since they are guaranteed by the government of the United States, TIPS are a good way for the average investor to protect himself from the risk of both financial loss and erosion of purchasing power. The only cons are that paper gains of rising TIPS value are regarded by the IRS as taxable income; also they can be volatile in the short run, making them perfect for permanent lifelong holding.

What about commodities?

Some argue that recent data is proof that we are on the verge of a new commodity supercycle, as commodities have outperformed the stock market in the last 12 months in what could be called a “silent boom”. In fact, while the S&P 500 finished 2020 with a gain of 16.26% last year, commodities prices have been booming as much as 326% (Lumber) and might keep going up because of inflationary pressures, that could be furthermore fueled by the US$ 2 trillion infrastructure plan coming from the Biden administration and energy transition plans around the world. To hedge against inflation by investing in a portfolio of diversified commodities, the average investor could choose a commodity index. Stay tuned and SUBSCRIBE to become a MarketsTalk member and get free access to discussions!